EU deal for Spain, Italy buoys markets but details sketchy

BRUSSELS (Reuters) - Under pressure to prevent a catastrophic breakup of their single currency, euro zone leaders agreed on Friday to let their rescue fund inject aid directly into stricken banks from next year and intervene on bond markets to support troubled member states.

They also pledged to create a single banking supervisor for euro zone banks based around the European Central Bank in a landmark first step towards a European banking union that could help shore up struggling member Spain.

“It is a first step to break the vicious circle between banks and sovereigns,” European Council President Herman Van Rompuy told a final news conference after talks which stretched right through the night.

The deal was widely seen as a political victory for embattled Italian Prime Minister Mario Monti and his Spanish counterpart, Mariano Rajoy, over German Chancellor Angela Merkel, who had brushed aside any need for such emergency measures earlier this week.

ECB President Mario Draghi endorsed the “tangible results”, which sent the euro nearly 2 percent higher and sharply cut Spanish and Italian bond yields. European shares rose, led by banking stocks buoyed by the prospect of moves to backstop the financial system.

“I am actually quite pleased with the outcome of the European Council. It showed the long-term commitment to the euro by all member states of the euro area,” Draghi told reporters.

Market participants welcomed the outcome as a substantial step to restore confidence in the 17-nation euro zone, which was saluted by a more durable rally than previous summit outcomes.

“It’s inching closer to a banking union, and the closer we get to a banking union would put (the EU) well on the road to a fiscal union,” said Art Hogan, managing director of Lazard Capital Markets in New York.

Most economists polled by Reuters expect the ECB to cut borrowing costs at its July 5 meeting, which takes place against a darkening economic backdrop. But internal resistance to the central bank reviving its bond-buying program remains high.

After 14 hours of tense talks that ended at 4:30 a.m. (0230 GMT), the 17 leaders agreed on a series of short-term steps to shore up their monetary union and bring down the borrowing costs of Spain and Italy, seen as too big to bail out.

To that end the euro zone’s temporary EFSF and permanent ESM rescue funds will be used “in a flexible and efficient manner in order to stabilize markets” to support countries that comply with EU budget policy recommendations, a joint statement said.

It gave few specifics, but euro zone officials said the funds could buy bonds on both the primary and secondary markets on the basis of a memorandum of understanding signed with the requesting state and up to a funding limit to be agreed.

Both Italy and Spain said they did not intend to call on that mechanism to stabilize markets for now, hoping the Brussels agreement will serve as a sufficient deterrent.

Washington said it was encouraged by the progress but White House press secretary Jay Carney told reporters travelling with President Barack Obama that “a lot of details” still needed to be worked out, and the euro zone was likely to need to take further steps in the future.

The International Monetary Fund said the summit had taken “the right steps toward completing monetary union” while ratings agency Fitch said the deal eased near-term pressure on euro zone sovereign ratings.

UNTHINKABLE DECISIONS

In a key concession by EU paymaster Germany, the leaders agreed to waive the ESM’s preferred creditor status on lending for Spanish banks, removing a key deterrent to investors buying Spanish government bonds, who feared having to take the first losses in any debt restructuring.

“We have taken decisions that were unthinkable just some months ago,” European Commission President Jose Manuel Barroso said.

European Council President Herman Van Rompuy addresses a news conference after a European Union leaders summit in Brussels June 29, 2012. REUTERS/Francois Lenoir

Despite the concessions by Berlin allowing euro zone rescue funds to be used more flexibly, questions remained about the terms, size and supervision of any future aid for Spain and Italy.

There was also no commitment for now to back up a European bank supervisor with a joint deposit guarantee or a common resolution fund, to avert capital flight and taxpayer losses. However, one EU official said that letting the ESM lend directly to banks once the supervisory body is up and running was a backdoor route to closer fiscal union.

Monti, determined to avoid the political stigma of the bailout terms imposed on Greece, Ireland and Portugal, said countries that complied with EU budget recommendations would not face extra austerity conditions or be subject to intrusive inspections by a “troika” of international lenders.

Eager to avoid the impression that she had blinked first, Merkel said strict conditionality would still apply to the use of rescue funds and countries would face stringent monitoring by the EU Commission and the ECB.

Asked if she had yielded to pressure, she said: “There is clearly pressure from financial markets. Some countries are in a difficult situation. The high interest rates affect the debt but also the real economy. We had an interest in finding solutions.”

Merkel reaffirmed her firm opposition to common euro zone bonds.

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She later won resounding approval in the lower house of the parliament in Berlin for funding the ESM and for new EU budget rules. A similar vote in the upper house was expected later in the day, though Germany’s constitutional court may still object.

The Spanish and Italian leaders had threatened to block a package of measures to promote growth to pressure Merkel to accept measures to ease their borrowing costs, delaying the talks. New French President Francois Hollande backed their calls for bold steps to help the bloc’s third and fourth biggest economies, adding to the pressure on Merkel.

Hollande, who had demanded a renegotiation of the fiscal pact to switch Europe’s focus from austerity to promoting growth, said he had achieved satisfaction at the summit and would now submit the treaty to parliament for ratification.

While Hollande could claim a step forward in “solidarity”, Merkel achieved little immediate progress on her demands for EU authorities to be given the power to override national budgets and economic policies. The issue was kicked down the road to October, when top EU officials led by Van Rompuy will deliver a more detailed report.

CAUTIOUS OPTIMISM

Economists applauded both the short-term measures to steady markets and the longer-term direction, saying that for once, after 20 summits since the crisis began in early 2010, euro zone leaders had exceeded admittedly low expectations.

“I think the ECB being made the banking supervisor is actually the biggest long-term step because it points the way to banking union,” said Megan Greene, analyst at Roubini Global Economics, which is often gloomy about the euro zone’s future.

“The move to recapitalize banks directly is a big deal and will help to break the ‘vicious circle’ between banks and sovereigns that has been at the very heart of this crisis,” said ABN AMRO economist Nick Kounis, although he added that the euro zone remained “in a muddling-through scenario”.

The ESM’s ability to inject capital directly into banks will come too late to help Spain recapitalize its debt-laden lenders immediately this year, but it should allow Madrid to remove the cleanup from state books next year, euro zone officials said.

Merkel said finance ministers would have to work out whether the state or the banks would be legally responsible for repayment of the loans thereafter.

Some analysts were more skeptical about the benefits of the deal, given the level of detail left open.

Ireland, which had to take an EU/IMF bailout in 2010 after suffering a similar bank meltdown and property bust to Spain, hailed the decisions as a “game changer”, saying it would seek similarly favorable conditions for its own taxpayers.